STRIPs

Why Treasury STRIPs Have No Place In Your Portfolio

Have you heard of STRIPs? They are a type of Treasury bond. 

In my time I have recommended that my clients buy hundreds of millions of dollars – perhaps billions of dollars – of STRIPs. 

However, let me tell you why it will be a bad idea for you. 

Have you read the important notes? It’s a condition of visiting the blog. 

A Nice Breakfast

One day this January I emerged from an elevator in a large bright atrium of a major institutional money manager. I was welcomed at the top floor by a smart-suited group that were all smiles and I was ushered into a large airy conference room and carefully positioned on one side of the large table so I had an excellent view of Boston harbor. The sun glinted off the water in the crisp winter air and made sun ripples on the polished shiny surface of the table. Along the walls were artworks with sharp vibrant colors; clearly positioned to give the impression that this was a modern forward-looking firm that was extremely profitable. I could tell they were ‘artworks’ and not pictures since they had small plaques underneath with the artists’ details. I was offered hot coffee from a shiny chrome pot with a china cup, a choice of fancy pastries and a wonderfully presented plate of freshly cut fruit. (Have you noticed how much better fruit tastes when it is chopped into bite sized amounts by someone else?) The group exchanged pleasantries and chatted a little while everyone settled with drinks and snacks. I was made to feel that my every comment and joke was the most interesting and funny quip they had heard for years.

I was here to talk about purchasing around $200M of STRIPs for my client, a fairly typical allocation for a medium sized pension fund.

The manager had assembled a show designed to impress, but from a money manager’s point of view STRIPs are perhaps the dullest instrument in the investment universe. They are very simple and their return basically only depends on how interest rates and inflation changes in the future. With stocks you can pontificate on sectors, valuations, earnings, etc. But there really isn’t much trading you can do when you’re managing STRIPs. It’s not a sexy investment, but they were clearly hoping for additional business down the line and were rolling out the red carpet for me.

 

In the investment world STRIPs have a very definite purpose. They are bought by insurers and pension funds to meet their long term commitments. If you know you have to make a payment in 30 years’ time and need to set aside money today in order to meet that future obligation, then STRIPs are the perfect instrument.  They are bought in vast quantities by these institutions who prize their long term payment certainty and sensitivity to interest rates. If you buy a STRIP you know what you are going to get in the future, and if you are an insurer that needs to explain to the regulator how you are solvent then this is a good thing.

So I was pretty surprised to hear of individual investors buying 30 year STRIPs as they have some real risks

Treasury Bonds

You may be familiar with Treasury bonds. If you want to lend to the US government so they can buy more schools, roads, cruise missiles etc then you can buy a Treasury bond. It’s actually pretty easy – you just create an account at Treasury Direct, or use your friendly local broker. You pay over a minimum of $100 and in return you receive regular interest payments every six months, called coupons, and at the end of the bond’s term you get a return of your principal. The coupon payments are (usually) fixed and are your ‘reward’ for loaning the Government your money.

Alternatively, you can buy into a Treasury fund from the usual suspects like Vanguard, Fidelity, Schwab etc. This might be a mutual fund or ETF. 

STRIPs

STRIPs are Treasury bonds where the coupons have been removed and you are just left with the maturity payment. It’s sometimes called a ‘zero-coupon bond’, or ‘zero’.

Note that as a technical point, even though you receive no interest payments over the 30 years, the IRS requires that you recognize annual ‘interest’. These instruments are therefore more tax efficient in an IRA.

What's the Investment Pitch?

The pitch you will hear from 30-year STRIP proponents is the following.

Look at the size of that discount! That’s an enormous discount for buying a certain return over the future. You are absolutely guaranteed around 3% return currently because these things are safe as houses and backed by the full-faith and guarantee of the US Government making them safer than a savings account. But you wanna know the best thing? If rates fall then the price of these things will rocket and you could make a killing! So best case is you make an absolute killing, and the worst case is you make a certain return. It’s win-win!

Pretty compelling huh? 

But before you rush out to Treasury Direct let’s unpick this.

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Two Parts to the Pitch

You will notice that the pitch is essentially composed of two parts and I will tackle each separately. Let’s highlight them in more detail. 

It’s a little bit like being given a winning lottery ticket for $1,000. However you have to wait 30 years to collect your winnings, but there is a chance over the intervening period that the lottery ticket could pay $10,000! Sounds good right? Well let’s see….

PART 1 - Certain Return

This is true.

As far as security goes these are the safest investments around. Default by the US Government on loan payments is not a scenario that is taken seriously by anyone outside the most extreme fringe. The Government can always print money, and anyway if the US Government is defaulting then I can tell you now that all investments are going to shit and you should have put your money in guns and tinned food.

Are 30 year STRIPs more secure than money market accounts or funds? There’s not a lot of difference so I would ignore that as noise. Money market accounts are backed by FDIC insurance and money market funds have some backing from the Treasury if the broker fails. Essentially we’re talking about the difference between Qdoba and Chipotle. The most burrito-oriented aficionados might see a difference, but nah.

Let’s now look at part 1 – the purported benefits of holding to maturity through three lenses:

  • Inflation risk
  • Return expectation
  • Liquidity and opportunity cost

Inflation Risk

Yes, 30 year STRIPs can be bought at a nice looking discount. I know it feels a bit like buying a certain payout of a $1,000 lottery ticket for only $450. Yeah I know you have to wait for 30 years to collect your winnings, but that has to be a good deal – right?

Nope.

These are some of the longest-term instruments you can buy. And 30 years is a long time during which your money can erode with inflation. It’s great that you will get $1,000 in three decades, but if inflation is high then it is entirely possible that you lose money on STRIPs in inflation adjusted (‘real’) terms.

Let’s look at that in more detail.

Currently (5/31/2019) STRIPs are yielding around 2.6% a year. That means that if you buy a STRIP for $450 you will be certain to see a return of 2.6% per year for 30 years. That’s a low return by any standards and should be enough to set off alarm bells. But let’s give this the benefit of the doubt and bring some rigor to the analysis. 

If you hold a 30 year STRIP to maturity and future inflation is above 2.6% then you lose, and if inflation is below 2.6% then you make some real return on your money. 

Historically inflation has been a mixed bag.

 

In the chart below I’ve shown the historical inflation rate for the last century and helpfully color-coded years with inflation in excess of 2.6% in red and below 2.6% in blue. You can see there have been plenty of post-war years with both. 

In plain English – if future years have a lot of red then you have lost your shirt on the STRIP

STRIPs

But What About Future Inflation?

The above chart shows past inflation, but what about the future? 

I dunno.

I could waffle on about my views but the fact is that I just don’t have a better insight into this issue than the banks, brokers or money managers that are buying and selling STRIPs.

Remember that money manager I visited in Boston? Behind the glitzy façade and fancy breakfasts they have a sweat-shop of economists, traders, actuaries etc setting their views on economic direction including inflation. These views help to shape the supply and demand price of STRIPs. The discount you receive has baked into it the collective views of the market on future inflation. If you think inflation will be less than what the market thinks, then maybe that’s a reason to buy, but I don’t believe you have a 30 year forecast of inflation that’s superior to anyone else.

Beware the person you meet that re-assures you that we are in a persistent low inflation environment. That may be the case over the next five years, or maybe ten years, but extrapolating for 30 years shows a lack of humility and a reckless excess of hubris. And would you tie up your money for 30 years based on that?

Hey! Chill Out!

Extraordinarily – in response to my inflation concerns I’ve had the response – hey AoF take a chill pill! If inflation goes up significantly I will just sell my STRIPs and buy into inflation protected bonds (“TIPS”). 

Let me play back to you how this will turn out. 

  • Inflation rises unexpectedly, or there is the hint that inflation could rise unexpectedly. This could be due to any number of reasons; war with Iran, oil crisis, new government introduces massive infrastructure spending… there are plenty of valid scenarios. 
  • The market quickly reacts with STRIPs sellers slashing prices to make them more attractive to buyers in the face of impending inflation risks. 
  • Similarly the price of inflation protected bonds (TIPS) will rise dramatically as the demand for inflation protection in the new environment will attract a premium. 
  • You are then selling your STRIP at a low and buying TIPS at a high. Sad!
Also, don’t tell me that you will anticipate this high inflation event in advance. Do you know how fast the market reacts? The market does not react to changes in inflation, that would be months too late. They don’t even react to changes in policy that might impact inflation – that would be way too late. The bond market reacts instantaneously to rumors or even suggestions that there might be a sniff of future inflation. 
 
A perfect example is the election of President Trump in November 2016. The following chart shows how the price of STRIPs reacted over those few days. 
STRIPs

See the precipitous decline in November 2016? The market was rapidly assessing Trump’s policies and their impact on inflation. The market quickly decided that the Trump spending plans (remember the wall?) would push up inflation and so the price of STRIPs were slashed. This pricing correction was essentially instantaneous and based on nothing more than speculation about how Trump could impact the next 30 years of price inflation. 

Do not tell me you are going to get ahead of that because some guy on facebook has posted a CNBC article. 

Let’s move on from inflation risks to whether holding STRIPs to maturity is a good idea in terms of nominal return. 

What About Return Expectations?

You might ask yourself whether the current discount on STRIPs is favorable. Currently a $1,000 face-value STRIP is around $450. But is that a good deal? What if it was $500, or $400? How should we think about this?

The way to think about this is to look at the current yield. The current discount on STRIPs implies a yield of around 2.6% a year. This is the same as saying that you can buy a $1,000 face value STRIP for $450, just put into yield terms.

The chart below puts that into historical context. Low yields mean high prices for STRIPs. 

STRIPs

Over the last few decades interest rates have been falling, particularly at the long-end. You can see that historically yields on 30 year STRIPs are at an all-time low, and prices are at an all-time high. (By the way that weird gap resulted from when the Treasury temporarily suspended the issuance of 30 year debt.)

Does this make 30 year STRIPs a bad deal?

Not necessarily. Who knows what an appropriate yield is? A nominal return of 2.6% might be entirely appropriate for the next 30 years if inflation remains rock-bottom and rates continue to fall. But the fact is that you are buying 30 years STRIPs at all time high – that’s never a good feeling.

Liquidity and Opportunity Cost

Remember we are still assessing  PART 1: If you hold the 30 year STRIP until maturity you will receive a certain return. 

We have covered inflation risk and the nominal return outlook. Let’s now look at what you are giving up by holding your STRIP to maturity. 

This section is just common sense and I don’t need any fancy charts (but I do have one).  

If you are being asked to tie up your money for 30 years then you are forgoing all opportunities with those funds. That could be an opportunity to invest in a real estate deal, buy stocks, invest in your cousin’s business, pay down your mortgage, pay off your kid’s student loan etc. 

Investors demand compensation for tying up their money and if I am going to tie up my money for three decades then I’m gonna need a lot of compensation! 

For example that’s why your return expectation for private equity should be so much more than for publicly traded stocks. The difference is that with a private equity deal you don’t have access to your money and can’t easily sell. 

I will contend that 30 years’ of 2.6% return is insufficient compensation for the illiquidity. But let’s look at comparing this return with cash – the most liquid investment. 

Comparison with Cash Returns

I had a quick look on Bankrate.com and there were four banks offering savings accounts yielding 2.4% or more. (That’s not even looking at CDs where your money might be tied up for a year!) This is a cash account with instant access, and you are earning only 0.2% less than a 30 year STRIP!

So a 30 year STRIP is rewarding you for tying up your money with an additional 0.2% a year in return. You don’t need to be a Wall Street genius to see that is garbage!

You don’t need fancy analysis, long words and academic literature to assess investments and spot a bad deal. Just ask some sensible questions like “how does this return compare to cash?“. 

To complete this section the following chart shows how the 30 year STRIP yield compares to the cash yield. You can see it’s historically low. In other words the compensation you are receiving relative to cash is low by historical standards. 

STRIPs

Let's Wrap This Up!

So far I have written 3,000 words on PART 1: If you hold the 30 year STRIP until maturity you will receive a certain return. 

I am going to break this post into two and the next post will tackle PART 2: If interest rates fall before maturity then you can sell it and make a fat profit. 

I’ve analyzed Part 1 by looking at three areas. 

  • Inflation risk
  • Return expectation
  • Liquidity and opportunity cost

I’ve shown that historically inflation has exceeded the current 30 year yield and if this were to happen in the future then any profits would be wiped out. I observed that future inflation risk is not something you can simply mitigate by selling your STRIP if things go south. 

I then looked at return expectations and I think it’s sufficient to observe that the yield on 30 year STRIPs is low any way you cut it; relative to cash, historically and in absolute terms. 

Finally I showed you that you are receiving a pittance of compensation for lending your money to the Government for 30 years.

I can’t imagine giving PART 1 a more conclusive kicking. If you are being urged to buy 30 year STRIPs on the basis of holding them to maturity then you are being mis-sold – plain and simple. 

However… we have yet to investigate PART 2. 

Will there be any merit to holding STRIPs in the hope that rates fall and you can crystallize a profit? You will have to see the next part of this post to find out!

Technical Notes

If you’ve done any finance or financial planning exams you might see STRIPs described as a suitable investment to match a future liability. For example you might have a child with future college expenses and so buying a STRIP provides you with a set-it-and-forget-it way of investing to meet that expense. That is valid reasoning…. for the short-term, or perhaps medium-term. But 30 years?!

The limitations I described above should dis-abuse you of that. 

Relevant post – How Should You Invest For the Short Term?  and College Investment Strategies. 

You might ask how I can be so duplicitous to recommend long maturity STRIPs for my clients and not for you? Pension funds and insurers derive a huge amount of accounting and hedging benefits from these instruments that out-weigh the disadvantages described above. Endowments, which have perhaps the closest goals to early-retirees’ goals, do not invest in 30 year STRIPs. 

I’m not anti-bonds. Not by any means. That is not what I am saying. Buy bonds for risk management purposes. Just don’t buy 30 year STRIPs with the intention of holding them to maturity. It’s dumb. 

Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my day job I advise corporate America on investment and retirement strategies. I am a qualified actuary, a registered investment adviser and have a PhD in mathematics and I reserve the right to include the occasional math post.

6 thoughts on “Why Treasury STRIPs Have No Place In Your Portfolio”

  1. I used it once. In 92 I bought a 200K zero coup with I think a 20 year term and 7% interest. I would have been 60 at maturity and wanted something to mature so my wife would have some money in case I kicked the bucket. This was when I was getting my portfolio off the ground, so I bought it as a kind of insurance policy. I sold it out in 2007 and used the money to buy stocks cheap in the ensuing debacle. You gotta ask yourself how can a cabbie afford 2 new cars and a boat and a house. I asked myself that in 2007 and the answer came back “he can’t” so I knew the end was near. Wish I could have figured out the short on “2 new cars and a boat” but I wasn’t an actuary, but I did OK

    1. actuary on FIRE

      I’m gonna give you a pass on that zero purchase – real yields were so much more attractive in the 90’s and the life insurance angle to this purchase is a good one.

      In the next downturn I think the asset class to short will be student loan ABS (SLABS)! Student loan debt is astonishgly high and has been immune to the post ’08 de-leveraging.

  2. They don’t allow bankruptcy and you can’t just put the key in the mailbox and walk away. I was reading an article how some are becoming ex-pats and moving to India to avoid the debt. Only problem it’s 123 degrees in India. Forgot to mention my zero coup was a muni so I avoided taxes also.

  3. I have a single strip it my portfolio, albeit it’s a ten year not a 30. On the one hand at the time I was looking for a ten year bond for my bond allocation. It had the best return in that market and for its face value the coupons of an equivalent tbill wouldn’t make a appreciable difference in duration. So I guess I don’t see the ten year strip as that bad as an investment in the correct interest rate environment for a volatility dampening play…
    but…
    The tax treatment on these things is a royal pita. Calculating phantom interest on these every year to pay taxes on is not with it. For that reason I’ll never buy another strip.

    More generally and too your point I wouldn’t recommend any fixed income investment to an individual with a duration beyond ten years. The inflationary risk is just too high on that timeline. After all the impact of inflation on a bonds price and thus its yield is measured as a factor of its duration.

    1. actuary on FIRE

      I agree with you a duration more than 10 years for a buy to hold strategy doesn’t make sense. But buying a STRIP could make sense for tail risk protection – that I explore in part 2.
      I have calculated the interest in theory in classes, but never in practice. So getting a practical view on that from you was interesting. Thanks!

  4. Jonathan D Morgan

    Your entire piece is devoid of the 3-dimensional lens with which a portfolio is put together. No one is advocating a portfolio of 100% 30-year STRIPS. However, STRIPS provide some very real benefits for some investors.

    1. They provide a guaranteed rate of return if held to maturity, and on this we agree.

    2. They can help retirees meet their long-term investment goals, as part of a long-term portfolio where an LDI approach is sought or being pursued by a qualified investment professional.

    3. STRIPS especially at the long end of the curve, provide a negatively correlated asset that can smooth out the equity volatility in the portfolio during a left tail event.

    Your fear mongering about inflation is just that, fear mongering. No one says they know anything about the next 30 years. Nor does anyone advocate that you have to own a STRIP for 30 years. But the realities of today’s environment where you have a severe debt overhang, and a situation where velocity has fallen to levels not seen for 50 years, you have an environment that has made them very advantageous to hold, which you conveniently left out of your piece for obvious reasons, it doesn’t fit your pre-conceived narrative about Treasuries. As you represent the interests of Wall Street, and banks for a living what else should I expect.

    Your point about selling STRIPS and buying TIPS, again, demonstrates your lack of knowledge about how to build a bond portfolio, or how this works in real life. The research clearly demonstrates that investors are far better served by holding short term TIPS for inflation protection, and long term Treasury bonds for deflation protection and negative correlation to left tails. This allocation is maintained as part of the portfolio exactly because you can not predict the future. Just because one can not predict the future does not mean you do not plan for multiple scenarios.

    Your points about opportunity cost, and liquidity are ludicrous.
    1. Again, no one says you have to hold it for 30 years. If another opportunity presents itself then you can sell it, or hold a lower duration instrument to begin with in anticipation of needing the money for some other investment so again, ridiculous.

    2. You make the following statement: “So a 30 year STRIP is rewarding you for tying up your money with an additional 0.2% a year in return. You don’t need to be a Wall Street genius to see that is garbage!”

    Aside from the passive aggressive jab at me, this statement is again ridiculous. So I know that you know how these bonds work, so I am not going to insult you by saying you don’t, instead I will say that this is a statement with a clear intention to mislead the uninformed reader.

    Treasury bonds like STRIPS have two separate levers of return. The first mechanism is the YTM (Yield to Maturity). The second is the fact that these bonds trade on the open market, and provide an opportunity for capital gains just like stocks do. Your comparison of a 30 year STRIP to cash is also inappropriate. You don’t compare 30 year bonds to T Bills, they are completely different instruments for completely different purposes.

    Also, instead of putting fancy lines like
    “You don’t need fancy analysis, long words and academic literature to assess investments and spot a bad deal….or….Do not tell me you are going to get ahead of that because some guy on Facebook has posted a CNBC article… or Beware the person you meet that re-assures you that we are in a persistent low inflation environment. That may be the case over the next five years, or maybe ten years, but extrapolating for 30 years shows a lack of humility and a reckless excess of hubris…”

    Be a professional in the future, and engage in a conversation with those you disagree with. Academic debate is the hallmark of intellectual progress, and unlike you I am always happy to engage in discussion and explain the reasoning behind my views. You will probably delete this from your site, if your past behavior is any indication of how you deal with criticism, so I am also posting this to Facebook in the group where you stole all of my content that you used for this and your other posts.

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